Capital Budgeting Analysis
Part 1
Machines cost – $200,000
Shipping cost – $10,000
Installation cost – $30,000
Salvage value – $25,000
Years of life – 4
Tax rate – 40%
Capital cost – 10%
Units sold – 1,250
Sales price per unit – $200
Incremental cost per unit – $100
Rate of inflation – 3%
Net working capital rise – 12%
Depreciable Basis = Machines + Shipping + Installation costs
= $200, 000 + $30,000 + $10,000 = $240,000
Depreciation expenses = % * Basis
| Year | % | Basis | Annual Depreciation Expenses | |
| 1 | 0.33 | $240,000 | $79,000 | |
| 2 | 0.45 | $240,000 | $108,000 | |
| 3 | 0.15 | $240,000 | $36,000 | |
| 4 | 0.07 | $240,000 | $16,800 | |
| Annual sales revenues and costs | Year 1 | Year 2 | Year 3 | Year 4 |
| Units | 1250 | 1250 | 1250 | 1250 |
| Cost per unit | $100 | $103 | $106.09 | $109.27 |
| Sales price per unit | $200 | $206 | $212.18 | $218.55 |
| Revenue (3% increase) | $250,000 | $257,500 | $265,225 | $273,182 |
| Net working capital (12% increase) | $30,000 | $30,900 | $31,827 | $32,781.81 |
| Annual Incremental operating cash flow statements (Investment revenue $240,000) | Year 1 | Year 2 | Year 3 | Year 4 |
| Revenue | $250,000 | $257,500 | $265,225 | $273,181.75 |
| Costs | $125,000 | $128,750 | $132,612.50 | $136,590.88 |
| Depreciation | $79,200 | $108,000 | $36,000 | $16,800 |
| (Operating income before tax)EBIT | $45,800 | $20,750 | $96,612.50 | $119,790.88 |
| Taxes (40%) | $18,320 | $8,300 | $38,645 | $47,916.35 |
| Net Income | $27,480 | $12,450 | $57,967.50 | $71,874.53 |
| Net operating CF (net income +depreciation) | $106,680 | $120,450 | $93,967.50 | $88,674.53 |
| FCF | $76,680 | $89,550 | $62,140.50 | $55,892.72 |
| Discounting factor | 0.9090909 | 0.826446281 | 0.751314801 | 0.683013455 |
| DCF (240,000) | $69709.09 | $74008.26 | $46687.08 | $38175.48 |
NPV = -11420.09
Payback method CF = $284,263.22
Payback method does not consider the time value of money and therefore considering that this investment should not be considered
NPV is the difference between the present value of cash inflows and the present value of cash outflow over a while. IRR is the internal rate of return. It is the rate at which NPV is zero. PI is measure by the use of the payoff accrued of the investment.
Since we got a negative NPV, we should not consider this project.
Part 2. Working Capital Management
| Expected Sales | 150000 | Net profit | 150000/0.06 = 2500000 |
| Net profit | 0.06 | Return on assets | 2500000/2.27 = 1101321.586 |
| Inventory turnover | 7.5 | ||
| DSO | 36.5 | ||
| Cost of goods sold | 121667 | ||
| Fixed assets | 35000 | ||
| Payable deferral period | 40 | ||
| A). | C). | ||
| Inventory days | 365/7.5 = 48.67 | Inventory turnover | 9 |
| Cash conversion cycle | (36.5+48.67)-40 = 45.17 | Inventory | 121667/9 = 13518.56 |
| B) | Inventory days | 365/9 = 40.56 | |
| Accounts receivable turnover | 365/36.5 = 10 | Cash conversion cycle | 40.56+36.5-40 = 37.06 |
| Accounts receivable | 150,000/10 = 15,000 | Total assets | 13518.56+15000+35000= 63518.56 |
| Inventory | 121,667/7.5 = 16222.27 | Asset turnover | 150000/63518.56 = 2.36 |
| Total assets | 15000+16222.27+35000 = 66222.27 | Return on assets | 2500000/2.36 = 1059322.034 |
| Asset turnover | 150000/66222.27 = 2.27 |
Part 3: Dividend Policy
El Ansary and El-Azab (2017), asserts that dividend policy is established within the framework of the general financial plans of the firm.
Dividend irrelevance is a theory that posits that investors are apathetic between dividends and capital gains, leaving the dividend policy inapplicable based on its impact on the firm value. Bird-in-the-hand refers to a theory that a dollar of dividends in the hand is preferred by investors compared to a dollar left in the business, where the dividend policy would affect the value of the firm (Priya and Mohanasundari, 2016).
MM proposed the dividend irrelevance theory. The theory is based on the assumption that there are zero taxes, zero flotation, and zero cost of the transaction. MM asserted that paying out a dollar per share of dividends lowers the rate of growth in dividends and earnings since new stock will need to be sold to stand in for the capital paid out as dividends. Under his assumptions, a dollar of dividends will cut the price of the stock by just $1. Thus, according to him, stockholders are supposed to be indifferent between dividends and capital gains.
According to Priya and Mohanasundari (2016), the bird-in-the-hand was formulated by Myron Gordon and John Lintner, who asserted that investors see a dollar of dividends in the hand to be better than a dollar of intended prospects in the wind, therefore stockholders will prefer a dollar of real dividends than a dollar of retained earnings.
The tax preference theory established that two tax-related issues exist for believing that investors might go for a low dividend payout to a high payout. The first reason is that taxes are not remitted on capital gains until the stock is sold and secondly when a stock is held by someone until they die, there will be no capital gains tax. This is because the beneficiaries receiving the stock can utilize the value of the stock on the day of death as their cost basis and therefore evade capital gains tax (Priya and Mohanasundari, 2016).
B).
Assuming that the dividend irrelevance theory holds, then the dividend payout will not have any consequences, and the firm might seek to pursue any dividend payout. If the bird-in-the-hand theory is correct, the firm is supposed to set a bigger payout if it seeks to increase the price of its stock. Assuming the tax preference theory holds, the firm is supposed to formulate a low payout if it intends to increase the price of the stock. Thus, these theories conflict with each other.
C).
According to Farrell, Unlu, and Yu (2014), stock repurchase is a case where a firm decides to distribute its cash among its stakeholders by repurchasing its stock rather than paying out cash dividends.
Advantages of Repurchases
Repurchases allow stockholders to choose if they want cash, they can tender their share, receive cash, and pay taxes, or they can retain their shares and evade taxes. Repurchased stock can also be used during mergers, during stock option exercise by employees, during the conversion of convertible bonds, and when warrants are exercised. Repurchased stock can also be sold in the open market if the firm requires cash. Repurchases are capable of eliminating a bigger block of stock that overhangs the market and minimize the price per share (Farrell, Unlu, and Yu, 2014).
Disadvantages of Repurchases
The price of the firm’s stock could reduce if a repurchase is taken as an option for a few good investment chances by the firm. Relatively, a repurchase could mean to stockholders that the managers are not involved in the building of the empire, where funds are invested in low-return projects. The firm may also raise the stock price and end up giving a higher price for the shares. In this case, the selling shareholders might gain at the expense of the remaining shareholders (Farrell, Unlu, and Yu, 2014).
D).
A stock dividend means issuing new shares in place of remitting cash dividend. Stock split means that the amount of shares remaining is increased in an act that is not related to the payment of dividends (El Ansary and El-Azab, 2017).
According to El Ansary and El-Azab (2017), the main advantage of stock splits and stock dividends is that they increase the number of shares outstanding and, thus reduce the shares into more, and smaller pieces. If the dividend or split does not take place at the same time as some other events which would change views concerning the future cash flows, such as news about greater revenues, then someone would expect the value of the stock to change in a way that the wealth of each investor remains the same.
Stock splits and dividends might be influenced by the belief that they are indicators of management believes that the future is better. If the management of the firm chooses to split it’s stock or remit stock dividends based on anticipated gains in the revenues and dividends, then the split/dividend action could give a positive signal thus boosting the price of the stock. Nevertheless, in a case where cash dividends and earnings fail to rise subsequently, the stock price would reduce back to its range, or get lower, since managers may lose their integrity (El Ansary and El-Azab, 2017).
Part 4: International Financial Management
A).
Young and Ghoshal(2016), asserts that multinational Corporation is a firm that operates in an integrated fashion in different countries. Firms chose to expand into other countries due to many reasons.
- To search for new markets. Multinational companies venture into different countries to seek markets for their products. Companies such as Coca-Cola have expanded and created new niches around the world in search of new markets.
- To seek raw material – Multinational companies such as Oil companies have pushed across borders and around the world to look for new sources of oil. Raw materials are an essential part of any companies and many companies would go long distances in search of it.
- To search for new technology. No country has the lead in all aspects of technology, thus many companies are venturing into different countries to seek new and emerging technologies.
- To avert political and regulatory problems – Most companies choose to operate in countries where there are no restrictions and import problems.
- Diversification – Firms seek to establish international production facilities and markets to cushion the effects of unfavorable economic trends in a single country.
B).
- Different currency denominations. Cash flows in different parts of multinational corporate structures are denominated in diverse currencies. Therefore, an examination of the rates of exchange, and the impacts of reducing values of currency, is supposed to be involved in every financial analysis.
- Language disparities. Communication ability is important in every aspect of the business. Multinational firms need a better understanding and knowledge of other languages for their success.
- Economic and legal consequences – Every country has its own political and economic institutions, and differences in these institutions can lead to significant hurdles when a firm is coordinating and controlling its international operations. Different legal systems can also cause complicated legal issues.
- Different cultures. Every country or region has a unique cultural heritage that determines its values and influence how a business survives in society. These differences have profound effects on the consumption habits, attitudes towards risks, how the firm deals with employees, and much more.
- Political risks. Every nation has a sovereign right over the property and people. Therefore, a government can hold the assets of a multinational company, or limit the return of earnings from the country and the company will not have a way of recovering its resources.
- Role of the government. Most governments do not create a favorable environment that can enable free and fair enterprise competition. Some governments assume an active role in business issues, requiring a multinational company to consult with the government directly to carry out its business.
C).
Exchange rate risk is a case where the volatility inherent in a floating rate of exchange systems for a multinational corporation increases the uncertainty of cash flows that must be translated from one currency to another. The exchange rate risk is determined by this increase.
D).
According to Valdecantos and Zezza (2015), before 1971, the rate of exchange was fixed. The U.S dollar was related to gold at a fixed price of $35 while other values of currency were based on the US dollar. The current monetary system is based on a floating rate system. The rate of exchange for any currency is fluctuating based on the fluctuation in the market. The intervention of the government is less. Currently, some countries still work with a fixed rate of exchange.
E).
According to Hassan and Mano (2019), spot rates are rates given to buying currency for immediate delivery, mostly two days after the date of the trade. Forward rates are the rates given to buying currency for delivery at some date that is agreed upon in the future.
In a situation where the forward currency is not as valuable as the spot currency, the forward rate is deemed to be at a discount to the spot rate. Equally, when a forward currency bears more value than the spot currency, the forward currency is said to sell at a premium.
F).
As Citrus Inc. plans to expand overseas, it should first consider its reasons for venturing it the international arena. This will guide it to the right countries for its intended purpose. Additionally, the company should examine how different countries carry out its financial management and its effects. Knowing financial management in different countries will help the company plan what country to expand to. Generally, my responses will help the company plan for the right venture before its intended expansion.
References
El Ansary, O. A. E., & El-Azab, M. H. (2017). The impact of stock dividends and stock splits on shares’ prices: Evidence from Egypt. Accounting and Finance Research, 6(4), 84-96.
Farrell, K., Unlu, E., & Yu, J. (2014). Stock repurchases as an earnings management mechanism: The impact of financing constraints. Journal of Corporate Finance, 25, 1-15.
Hassan, T. A., & Mano, R. C. (2019). Forward and spot exchange rates in a multi-currency world. The Quarterly Journal of Economics, 134(1), 397-450.
Priya, P. V., & Mohanasundari, M. (2016). Dividend policy and its impact on firm value: A review of theories and empirical evidence. Journal of Management Sciences and Technology, 3(3), 59-69.
Valdecantos, S., & Zezza, G. (2015). Reforming the international monetary system: a stock-flow-consistent approach. Journal of Post Keynesian Economics, 38(2), 167-191.
Young, C., & Ghoshal, S. (2016). Organization theory and the multinational corporation. Springer.